Though the ETF wrapper’s genesis was in benchmark-tracking, with the launch of the SPDR S&P 500 ETF Trust (SPY) in 1993, active ETFs have begun to gain ground since their debut in 2008. Fixed income ETFs have been particularly well-suited for active management, especially in the current low rate environment.
With the return of near-zero interest rates in the wake of the pandemic, active fixed income managers can adjust interest rate sensitivity based on their prediction of the next Federal Reserve action.
Active managers can also conduct analysis on various credits, picking and choosing which might be best-positioned to make good on their debts.
In a space like municipal bonds, where funds hold bonds that are issued by states, cities, counties and other governmental entities, active management has a role that may be overlooked by investors and issuers alike. Every city, county and state will be confronted with issues that won’t be the same as those in another area of the country.
Muni Market Ripe With Inefficiency
With over 50,000 different municipal bond issuers, more than 1 million unique CUSIPs and little professional coverage, the market is ripe with inefficiencies that could be used by active management to add value.
Yet within municipal bond ETFs, active funds still make up only a small slice of the total assets. According to data from FactSet, there is approximately $8.1 billion in active municipal bond ETFs compared to $57.2 billion in their passive counterparts.
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First To Market
The first U.S.-listed municipal bond ETF is the iShares National Muni Bond ETF (MUB), and it is currently the largest ETF in the space, with $23.5 billion in assets. This means that this ETF alone holds over a third of all municipal bond ETF assets.
This ETF tracks a market-weighted index of investment-grade debt issued by state and local governments and agencies. Aside from being first to market, the fund is also the cheapest, ringing up at 0.07% in expense ratio. Along with the iShares Short-Term National Muni Bond ETF (SUB), these two ETFs are less than half the cost of the next cheapest municipal bond ETF.
In fixed income, expense ratio is of particular importance. Expected returns for this asset class are lower, so expense ratios can quickly eat into returns. Yet active management’s ability to add alpha within this space means this extra cost can be more than made up for through sector allocation and security selection.
Active Can Add Alpha
The Hartford Municipal Opportunities ETF (HMOP) is an example of the power of active management in this space. The fund has outperformed MUB by 1.2% over the trailing year despite having an expense of 0.29%, over four times as high.
Chart courtesy of StockCharts.com
The ETF can buy high yield municipal bonds, which have higher expected returns relative to investment-grade municipal bonds found in MUB. While up to 35% of the portfolio may be in high yield, the portfolio currently only has about 12%, as the investment team does not feel current valuations are compelling.
The fund also considers ESG and climate factors when selecting credits for the portfolio. While climate risk to various municipalities might not be a critical part of investment analysis now, the increase in adverse weather events of the last several years is only expected to continue. This is another tool in an active municipal manager’s toolbox that would not be used by passive ETFs.
The IQ MacKay Municipal Insured ETF (MMIN) is another active fund that specifically invests in insured municipal bonds. The insurance on these bonds guarantees principal and interest payments in exchange for a lower yield. The current yield to maturity for the ETF is 1.94% compared with 2.11% for MUB.
Municipal defaults are rare—especially in relation to corporate bonds of similar quality—but have been increasing over the prior 10 years. COVID continues to present challenges for areas of the municipal market, especially for things like airport revenue bonds should the delta variant continue to hinder travel. (Read: Delta Variant’s Impact on ETFs)
Though defaults remain exceptionally rare, MMIN’s management team has been able to add more value than MUB’s passive approach did during the course of 2020. MMIN returned 7.5% for the year versus MUB’s 5.1%.
Chart courtesy of StockCharts.com
Munis were hit hard by COVID fears as panicked investors pulled money out of municipal bond funds, creating a liquidity crisis in mid-March. While MMIN was not immune to this sell-off, the fund’s active approach allowed them to take advantage of this short but painful market dislocation, handily beating MUB’s return for the year.
In contrast to HMOP’s dedicated high yield exposure, MMIN’s appeal is the removal of credit risk due to the bonds being insured. But as the performance above shows, even this high-quality take can add value through an active approach to the space.